Ideas

Whatever I feel like talking about.

Saturday, January 31, 2009

Stimulus: The Power of Names

A well chosen name wins an argument by assuming its conclusion. Label cash subsidies to foreign government as "foreign aid" and who can be so hard hearted as to oppose them. Call subsidies to the public schools "aid to education" and you neatly skip over the question of whether additional spending in the public school system results in more education. Label something "pollution" and is no longer necessary to offer evidence that it is bad, since everyone knows pollution is bad—even thermal pollution, otherwise described as warm water. Occasionally we even get dueling names. Both "right to life" and "pro-choice" are obviously good things; how could anyone be against either?

For a more recent example, consider Obama's economic policy. Everyone—including Obama, back when he was running for President—is against deficit spending. Relabel it "stimulus" and everyone is for it. The label neatly evades the question of whether having the government borrow money and spend it is actually a way of getting out of a recession—a claim for which evidence is distinctly thin. It is stimulus, so obviously it must stimulate.

The success of the relabelling with the general public is not surprising. What is somewhat surprising is the way in which much, although not all, of the economics profession has suddenly adopted as gospel the 1960's Keynesianism that most of the profession rejected several decades back. Everyone talks as though deficit spending was a way, indeed the way, of reducing unemployment, a central recommendation of that theory.

One explanation, of course, is that government spending is popular, taxes are unpopular, so a argument that converts deficits from a problem to a solution has a lot of natural supporters. But that is not the whole story.

Another part of it is that the credit crunch seems to bear at least a family resemblance to what Keynesians expected to see, indeed believed they had seen, as the cause of depressions. Interest rates are so low that holding money makes more sense than investing it, so demand drops, so everything spirals down—underemployment equilibrium due to the economy falling into the liquidity trap. The solution they proposed was fiscal policy. The government borrows the money that was accumulating under mattresses, spends it, gets things going again.

There is, however, one small problem with this account of the present situation. The Keynesian liquidity trap was supposed to be a result of running out of investment opportunities. All the productive things that could be done with capital had been done, so firms were only willing to offer a trivial reward to investors, so nobody bothered to invest.

That story has nothing to do with what actually happened. Firms are eager to borrow money and invest. The problem is not that we have exhausted investment opportunities but that lenders don't know what borrowers, or what intermediaries, to trust, due to a malfunction of the capital markets set off by the bursting of the housing bubble. One can argue about who to blame for that malfunction and what to do about it. But whoever is to blame, it is not a liquidity trap, hence it isn't any reason to resurrect the economic doctrines of fifty years ago.

The first round of "stimulus" proposals, whatever their faults, could at least be defended as a response to the actual problem. Lenders did not know who to trust but did trust the Federal Government. So let the government borrow the money from them, lend it to the firms that needed capital, and so keep those firms from being destroyed by a temporary freezing up of the capital markets. Skeptics might express doubt as to the competence of the government to allocate capital, but at least the policy could be seen as an attempt to get capital allocated.

The current proposal has no such defense. It simply consists of borrowing very large amounts of money and spending it. Insofar as it has any effect on the ability of firms to borrow, it makes it harder, since public borrowing is competing with private borrowing. A dollar I spend in government securities floated to fund the deficit is a dollar I don't invest in a private firm.

Sunday, January 18, 2009

Rationality, Nudges and Slippery Slopes

In order to explain and defend the economic approach to human behavior one must justify the assumption that individuals are rational, that they tend to take the actions that best achieve their objectives. One argument I have long made is that, while rational behavior is not a complete description of how humans act, it describes the predictable part of their action. In most situations there is one correct way of acting to achieve an objective and lots of incorrect ways someone could act. Unless one has a theory of what particular mistake someone is going to make, the best approach is to treat the mistakes as random error, to predict his behavior on the assumption he is rational while realizing that the prediction will sometimes be wrong.

So far as I know, neither Cass Sunstein nor Richard Thaler ever read either of the books in which I made that argument. But their recent book Nudges offers a rebuttal. Using evidence from behavioral economics, they argue that irrational action is not merely random error. There are patterns to it, predictable ways in which individuals act that are inconsistent with the economist's assumption of rationality. Thaler and Sunstein propose that those setting up alternatives for someone else to choose among—"choice architects" in their terminology—can and should take advantage of those patterns to nudge the chooser into making the choice they think he ought to make, the choice he would make if he were fully rational. This is the approach that I described in an earlier post as "soft paternalism" and that has been described elsewhere as "libertarian paternalism." It is paternalism because it is getting people to act as someone else thinks they ought, libertarian because it leaves the individual free to act in a different way if he wants to—a nudge, not a compulsion.

The argument as stated is persuasive and interesting. As the authors point out, any time you are offering someone else choices—whether "you" are a government agency, an employer, or a firm selling something—you are necessarily deciding in what form to make the offer, hence engaging in choice architecture. If you are going to do it, you ought to know what you are doing and do it in a way designed to produce the result you want to produce—in their case, choices that result in the chooser better achieving his own goals.

The libertarian part of the proposal depends on leaving the individual free, at no significant cost, to make the choice you don't want him to make. But if you don't want him to make that choice, it will be tempting to make it more and more difficult—to require him to fill out forms, file them in the right place, perhaps even to neglect to tell him that forms exist to be filled out, that the alternatives you don't want him to choose are available. There is thus a serious slippery slope problem, making it possible for libertarian paternalism to be used as the justification for government actions that end up as paternalism, or compulsion for other purposes, that is far from libertarian. The point occurred to me when I read the book. It was reinforced by a real world experience at about the same time.

It was the beginning of my daughter's first year at college and the college sent us a bill, a list of charges and a total we were to pay. One of the items in the list, included without explanation, was ten dollars for the "Green Edge Fund." Being curious, I did an online search to find out what it was. It turned out that it was a fund to subsidize environmental projects by students. It had been voted in the previous year—as an optional ten dollar per pupil payment.

"Optional" means that you don't have to pay. We sent in our check minus the ten dollars and I sent an email to the president of the College, pointing out that he was billing parents for money they did not owe. I received back an apologetic email from an administrator, explaining that the program was a new one and they had not yet gotten everything set up properly.

A month or so later I received a bill from the College for ten dollars. I wrote back to the office that sent the bill, pointing out that they had billed me, and all other parents, for ten dollars we didn't owe, that rather than my owing them money they owed money to all of the parents who had paid the ten dollars. I also sent an email to the administrator. A few weeks later, I received second bill for ten dollars—shortly followed by an email from the administrator telling me that the matter had been taken care of and I could ignore the bill.

Recently we got our bill for the second semester. It included a form for our daughter to sign and hand in during the first two weeks of the semester requesting a waiver of the charge for the Green Edge fund. The form contained a description of the fund—put in terms of how the money would be used, not how they hoped it would be used—that I suspect most students and faculty at the college would regard as fraudulent advertising if it were the product of, say, the phone company.

The bill did not include any mention of the fact that the College had, in the previous semester, charged parents for some tens of thousands of dollars that they did not owe, nor any offer of a refund to any parent who wanted it.

As it happened, my wife went to the same college thirty-some years earlier—and had had a similar experience. In her day it was a one dollar per student charge to support one of Ralph Nader's PIRGs. A student could get out of it by going to the right office on the right day and telling them he didn't want to pay it. On further enquiry, we discovered that the one dollar per student "donation" was still there, although there did not seem to be any effort to inform parents or students that they had the option of not paying it.

An optional charge where the default choice is to pay it is the sort of thing Sunstein and Thaler propose, a nudge in the direction of doing what those responsible believe, possibly correctly, that most of those nudged would want to do if they took the time to think about it. But the people constructing the choice architecture know what result they want to get, they believe they are doing good and so not constrained by what they themselves would consider proper principles of morality and honesty in a commercial context, so it is very easy to make the "wrong" choice more and more difficult and obscure until what is optional in theory becomes mandatory in practice.

Thursday, January 01, 2009

World of Warcraft: A Course Proposal

Suppose you are teaching economics at a large university and want a new way of getting the interest of your students. It occurs to you that a substantial fraction probably play World of Warcraft. It also occurs to you—since you too play WoW—that the game contains a complex economy that poses all sorts of interesting questions for an economist. You announce a new course—WoW economics—and get a gratifying large enrollment. Now what?

WoW has markets and prices, including an auction house with many buyers, many sellers, and a wide range of products for sale. Prices are readily observed—starting prices, buyout prices, relative prices at one time, changes over time. Actual sales prices are a bit harder, but if your students are active players they are probably buying and selling things and could be persuaded to keep track of prices paid and received and make the information available to the rest of the class.

Consider one simple puzzle—relative prices of ore. Low level players mine copper, higher level iron, mithril, thorium, … . What determines relative prices? One’s first guess might be that prices are higher the higher the level of the ore; a high level player can mine low level ores but not the other way around, making the potential supply higher at the lower level. And higher level ore is used to make metal used to make weapons and armor useful to higher level characters, who typically have more virtual gold to spend.

It sometimes works, but not always. One reason is that ore is a joint product. Some players may spend their time wandering around in search of ore to mine, but a lot of ore, I suspect a majority, is produced by players who are wandering around killing monsters and doing quests, happen to see a vein, and mine it. As the population of a server accumulates more and more high level characters, more and more time is being spent wandering in high level areas with high level ore, producing an increase in the supply of adamantium, a decrease in the supply of copper.

What about demand? High level characters need high level gear made from high level metal, so one might expect demand to shift in the same way as supply. What complicates that is the process of skilling up—becoming a better and better smith (or jeweler or leatherworker), able to make better and better stuff. Before you can make swords out of mithril you must first make them out of iron, before that copper (I simplify, as any WoW enthusiast will realize). If your high level character decides to take up smithing he must start at the bottom. Even if he himself is a miner, he is not spending his time in the low level areas where copper is mined, so goes to the auction house instead—bidding up the price of copper.

Patterns of prices change over time, sometimes in comprehensible ways. Not long ago a new option opened up in the game, a type of character that got to start not at level 1 but at level 55. Your brand new level 55 Death Knight fights like a level 55—but if he takes up smithing it will be at skill level 1. The effect on the relative prices of low and high end ore and metal is left as an exercise for the reader.

For a second example of WoW economics, consider the opportunities for arbitrage, both across goods and across time, and the implications thereof.. Any miner can, at the cost of a little time, convert a lump of iron ore into a bar of iron, or a bar of iron and a lump of coal into a bar of steel. The result should be a predictable relation between the market prices of lumps of ore and bars of metal, or of iron, coal and steel. You can look on the auction house and see if the pattern holds. Similarly, any predictable pattern of price changes over time—some things being more expensive on the weekend, say, when more players are online—should open opportunities for enterprising players to buy low, sell high, and make a profit. The result of players doing so should be to raise low prices, lower high prices, and eliminate the pattern. Does it happen?

There is no antitrust law in WoW, which makes it a good place to observe collusive behavior by sellers. My wife, who spends more time in the auction house buying ad selling than I do, has observed both an attempt to corner a market and an attempt, at least partly successful, to form a cartel—a cartel she was invited to join. Her refusal was met by a threat to drive her out of the market by underselling her. The organizer of the cartel had apparently not read Aaron Director’s analysis, reflected in McGee’s classic article on the myth of predatory pricing; it had not occurred to him that if he was selling, at an artificially low price, ten times as many gems as the interloper, he was also losing money ten times as fast. It took only a few days for him to discover the flaw in the strategy and abandon it.

These are a few examples I have come across of economics in the World of Warcraft. It should not be hard to come up with enough more to fill a quarter. If anyone wants to try it I will be happy to offer more suggestions.